In a first, the capital market regulator, the Securities and Exchange Board of India, has issued a show-cause notice to the country's leading stock exchange, National Stock Exchange, following a probe into alleged client code modifications by its broker members.

The notice has asked the bourse to explain the large number of client code modifications, three people familiar with the development said. The regulator also wants NSE to justify why action should not be taken against it for not exercising caution over such transactions.

Sebi was alerted about the dealings by the Central Board of Direct Taxes, which last year noticed that a large number of trades were reversed by changing client codes for tax evasion. While conducting audits, the tax department came across several instances where this facility was used by brokers to transfer gains or losses from one individual to another by modifying client codes in the guise of rectifying an error. This practice was rampant, especially in March.

Sebi independently verified the information given by the income-tax authorities and found it to be true, said a person familiar with the investigation. It then issued a show-cause notice to NSE for its failure as a frontline regulator. The tax loss to the exchequer was largely in the derivatives segment, one person said. A show-cause notice is not an indictment but contains allegations of violation. It requires the entity, in this case, NSE, to explain its side of the story.

When contacted, an NSE official declined to comment on the notice but said "At every stage, NSE has followed Sebi's guidelines on this issue and implemented them. In fact, as early as January 2010, on the basis of a complaint, the exchange took stringent action against some market intermediaries and put stronger monitoring mechanisms in place."

Stock exchanges allow client code modifications but only to rectify a genuine error that may have occurred at the time of placing or modifying the order. Every client is given a code which is registered with the stock exchanges. The broker is allowed to change it between 3.30 pm and 4 pm to rectify a genuine error that may have occurred while entering the code.

"This facility has been provided for the smooth functioning of the system and is expected to be used more as an exception rather than routine," the regulator had said.

In July, to further tighten the system, the regulator imposed a stricter penalty on such modifications. It instructed bourses to impose a monetary penalty of 1% of the value of the transaction where the client codes were modified. Brokers say the penalty is 50 times the yield in the F&O segment. The average yield in the derivatives segment is 0.02%. Moreover, exchanges have been directed to conduct special inspection of trading members to check whether such modifications are being carried on as per the criteria.

"Sebi's move to impose penalty on client code modifications is positive as they have been misused to make profit or book loss from stock market transactions," said Motilal Oswal Financial Services CMD Motilal Oswal. However, there could be genuine punching error while entering the code. Such mistakes can be exempted from the penalty after verifying their genuineness, Oswal said.

Sources said the number of cases of client code modifications has come down in NSE after it implemented stringent measures. NSE recorded a turnover of Rs 2,03,812 crore in the derivatives segment, while cash turnnover was Rs 14,274 crore on Friday.